What are Capital Markets?
The capital markets are a financial system of money management involving the trading of securities and other investment instruments: stocks, bonds, commodities and more. Capital markets provide a forum for companies to raise funds by issuing debt or equity securities. The key actors involved in the market according to Fintalent’s Capital Markets consultants include borrowers who want to borrow money from lenders, purchasers who want to buy investments from sellers, traders who help facilitate transactions and creditors that manage risk at all stages of the transaction process. People also use this system for transferring wealth between countries by buying currency on one country’s market and selling it on another’s.
Finance is the science that studies the theoretical evaluation of capital opportunities and the practical evaluation of capital projects. The capital markets are one venue for finance, in which issuers must meet formal and detailed standards to be considered financially sound enough to be given debt. Therefore, a borrower is only able to raise funds by issuing a security (i.e., bond or stock) if it meets certain standards set by lenders, who then are willing to entrust their money (i.e., debt) to that security.
Capital markets consists of three interdependent parts
The first part of the capital market system is the producers who issue debt securities and equity securities.
The second part of the capital market system is the intermediaries who help companies access the capital markets. The third part of the capital market system is the investors who purchase debt securities and equity securities from issuers.
Structure and operation of a Capital Market
In its most simple form, a capital markets system also consists of: (1) borrowers, (2) lenders and (3) investors. Most issuers go through one or more intermediaries before raising funds from investors. For example, an issuer will likely start its life as a small business or government-owned business, which are often not able to raise money on their own and therefore use intermediaries to help them raise funds. The intermediary then helps the small business or government-owned company to issue debt securities, also known as bonds. These bonds are sold to lenders, who in turn may issue their own debt securities (such as a bond or a loan). The lender then uses the proceeds from the loan to buy an investment (e.g., stock) on the market, which is issued by another issuer.
Issuance of Debt Securities
The issuance of debt securities will usually be handled by one or more institutional capital markets participants. In most cases, there are two main ways in which a company can raise funds: first-and-second lien bonds and senior unsecured loans. The primary distinction between these two forms of debt securities is that first-and-second lien bonds relate to rights to earnings in the future, while senior unsecured notes do not.
First and second lien bonds are debt securities that give investors the right to collect a share of corporate earnings in the future. The specific terms of these securities may or may not be dictated by an individuals or governments called a first lender, although this is typically the case. In contrast, senior unsecured loans are loans given out directly by corporations without going through another financial intermediary such as an investment bank.
Issuance of Equity Securities
An issuer can raise money in the capital markets by issuing equity securities such as stocks, convertible notes and convertible preferred stocks. These types of equity securities give buyers the right to ownership, voting rights and a share of profits. All three types of these securities are offered on major exchanges such as NASDAQ, NYSE and AMEX. Stock is the most common form of equity security because it is easy to trade, while convertible notes and preferred stocks require more specialized knowledge because they give different rights to holders and may or may not be listed on exchanges.
Investors purchasing bonds must carefully analyze the company issuing that bond before investing any money into it (i.e. “due diligence”). Company performance is a vital consideration because it indicates the risk of default and the extent to which a bond issuer can be trusted. In other words, bond buyers and issuers must assume that their own securities are not as secure as those of other corporations. Therefore, bond buyers/investors must assume that the profitability of companies in a particular industry may be lower or higher due to many factors such as technological advances, economic growth and governmental regulation.
Issuers tend to revive the market for the next generation of technology that could potentially replace their company’s practices. For example, Apple Inc. is widely seen as a technology company that has been shifting from a hardware company to software and entertainment content. Apple is not the only company in the market with this business model, but it is certainly the most significant. When businesses such as Apple and others make these sorts of changes, they should be concerned about their bond ratings. If a bond rating agency decides that these companies are lowering their bond ratings, it will cause a drop in demand for their bonds since investors will begin to doubt that they can pay back their loans. This also may effect the stock price of these companies since investors would be able to gain more bargaining power over the company since they have more options, and therefore have a more negative outlook on its future profitability.
A well-functioning Capital Market System makes it easier for issuers to raise funds by increasing the solvency of the “principal financial market participants” (i.e., investors and capital market intermediaries). The goal of a capital markets system is to facilitate more efficient funding and pricing of loans, bonds, insurance and various other financial instruments.
Capital markets lend themselves to efficient price discovery, since there exist well-defined securities (e.g., bonds, shares) with well-defined information about the underlying value of the security. Price discovery is a central feature in all types of capital markets transactions.
Finance, debt and real estate markets may influence one another as investors and lenders often have a preference for specific types of assets. These investors or lenders may have special knowledge about the value of specific assets, which may not exist in some markets. For example, securities and real estate are often traded in an illiquid environment. The reasons for this include that the secondary market is not large enough to absorb all supply, information asymmetry between buyers and sellers arises after buy-sell transactions, prices are not publicly available, private negotiations occur before trades are executed at an exchange such as Knight Capital Group which happens to be a direct participant in the capital markets system.
